Super stock returns: ROE/PTB vs ROE vs PTB (Part 1)

The following article is a good read for all Fundamental Analysts out there!

By TEH HOOI LING SENIOR CORRESPONDENT (Source: Business Times)

LAST week's article - In Search Of Super Returns In Stocks - struck a chord with readers and investors out there, judging by the number of emails I received.
For those who missed it, basically I screened all the stocks listed on the Singapore Exchange from 1990 until 2006 based on their return on equity and price-to-book ratio.
I then grouped the stocks into 10 portfolios with equal numbers of stocks, starting from those with the highest ratio when we divided ROE by price-to-book, to the lowest. This screening process can help us identify some mispriced stocks.

A company that is able to generate a high return on equity - one that exceeds its cost of equity - should trade at a higher price than the book value of its equity. And vice versa. But if a company generates a relatively high ROE, yet is trading at a relatively low price-to-book ratio (PTB), careful analysis is warranted.

There could be legitimate reasons for the low valuation. For example, the earnings were due to exceptional items. If not, the stock may be under-priced.
But without any detailed analysis other than simply grouping stocks based on ROE/PTB, I found that investors can actually generate super returns.

By investing in the 10 per cent of stocks with the highest ROE/PTB every year between 1990 and 2006, and holding each portfolio for a year, one could have turned $100 into $34,000 over the past 17 years. That's a compounded return of 41 per cent a year. All the calculations exclude transaction costs.

If we assume that the investor had lost 10 per cent of the portfolio value to transaction costs every year, the return is still a respectable 27 per cent a year. But in absolute terms the portfolio value today, at $5,678, is significantly less than the $34,000 which excludes transaction costs.

From the above, we can see that ROE/PTB is a good screening tool.

Super stock returns: ROE/PTB vs ROE vs PTB (Part 2)

By TEH HOOI LING SENIOR CORRESPONDENT

Separate rankings

If we pick stocks just based on ROE or just based on PTB, do we get results that are as good?
I decided to test this based on the same set of data last week. This time around, I ranked stocks based purely on their ROEs first. Again, I grouped them into 10 portfolios, with the first 10 per cent or first decile being stocks with the lowest ROEs. The 10th decile was made up of stocks with the highest ROEs.

As can be seen from the above chart, screening stocks using just their ROE still yields good returns. $100 invested in the highest ROE portfolio every year would grow to $8,752 today. That's a compounded annual return of 30 per cent.

But it would lag the performance of the basket of stocks with high ROE yet low PTB.
For both the first and second screening, I excluded loss-making companies.
Next, I ranked the stocks based on their PTB ratios. For this, I did not remove loss-making companies. The first decile is made up of stocks with the lowest PTB ratios. Some could even have negative PTB ratios. And the 10th decile consists of stocks with high PTB ratios.
As you can see from the third chart, there is a clear distinction in performance as well. The lower the PTB, the higher the return. And conversely, the higher the PTB, the lower the return. The lowest PTB stocks generated about 15 per cent return a year, while the highest PTB stocks chalked up a 7.3 per cent loss a year.

However, the returns of portfolio ranked purely on PTB ratio lagged those screened by ROE/PTB or purely on ROE.
One of the reasons for the under-performance could be the continued poor performance of loss-making companies. Other studies previously have found PTB to be the best predictor stock performance. Particularly so when there is a turnaround in the economy. This is also evident in five portfolios that The Business Times tracks every Monday.
But it takes guts to go against the crowd and buy into downtrodden stocks.

So perhaps, the ROE/PTB is a more comfortable approach for many. And as the results above indicated, it is rather rewarding as well.
It does, however, require a little more work. The use of ROE/PTB takes into consideration not only the underlying earnings capacity of a company, but also how much of that has been factored into its stock price.
So if a company can rake in good earnings and good growth and its share price has fully reflected that, it may not be a good stock to buy. What one wants is good earnings growth that is not recognised by the market.

Variations

A reader pointed out that with some simplifications, ROE is earnings per share (EPS) divided by net tangible assets (NTA). And PTB is price per share divided by NTA.
Dividing the former by the latter gives us EPS divided by price per share, which is earnings yield. So stocks with high ROE/PTB are also those with high earnings yield.
And we could go one step further. Earnings yield is the inverse of price-earnings (PE) ratio. So stocks with high earnings yield are also low PE stocks.

'Notwithstanding the mathematical accuracy, ROE relative to value is an interesting approach to investing,' he wrote. 'I have been using something similar for some time to good effect (ROE divided by PE coupled with some other criteria like minimum dividend payout and low debt to equity).

'A variation was also suggested in the book The Little Book That Beats The Market by Joel Greenblatt which uses ROE divided by return on invested capital (to correct for the use of excessive financial leverage). He even has a website www.magicformulainvesting.com to automatically select US stocks that meet the criteria.'

The reader added that the most comprehensive book he has come across on this is What Works On Wall Street by James P O'Shaughnessy.

So anyway, for the many who have asked, I have generated a table (above right) - using data from Bloomberg - showing 30 stocks with high ROE/PTB. Some of the numbers may be skewed by one-off items, so some analysis is advised before any action is taken.

Stock Review - YHI International

REVIEW OF Q107 FINANCIAL RESULTS

You can obtain the financial results here.

The Group’s turnover for Q1'07 (of S$96.0 mil) was S$0.2 mil or 0.2% higher than the S$95.8 mil recorded in Q1'06. Turnover from the manufacturing business increased by ~S$8.6 mil or 36.6% from S$23.5 mil in Q1'06 to S$32.1 mil in Q1'07. The increase was primarily due to increased output from additional production capacity in Suzhou, PRC.

Turnover from the distribution business decreased by approximately S$8.4 mil or 11.6% from S$72.3 mil in Q106 to S$63.9 million in Q107. The decrease was primarily due to exclusion of sales from Yokohama tyres in the PRC region as a result of formation of a joint venture entity in which the Group has a 49% stake. Distribution and administrative expenses were lower in Q1'07 as compared to Q1\'06 mainly due to lower advertising and promotional expenses and lower allowance for impairment of doubtful receivables.

Finance costs in Q1'07 were higher as compared to Q1'06 attributable to higher borrowing costs incurred.Total Group’s GPM Q1\'07 decreased by about 1.8% as compared to Q1'06 attributable to lower gross margin from manufacturing business which was mainly affected by the rising aluminum prices and also operating losses due to diseconomies of scale in the Malaysia plant which is currently operating on a single production line. The Group’s PBT increased by ~S$0.3 million or 3.7% from S$6.8 million in Q1'06 to S$7.1 mil in Q1'07. Total current assets increased by ~S$13.1 mil due to increase in receivables of ~S$12.5 million, and in inventories of ~S$4.4 mil together with a reduction of S$3.5 mil in cash. The increase in trade receivables was due to timing differences and this is in line with normal trading activities.

The increase in inventories was primarily due to higher stockholdings in view of price increases from suppliers. The reduction in cash was primarily due to working capital changes. The increase in available-for-sale financial assets of ~S$0.4 mil was due to additional investments in Hangzhou Yokohama Tire Co Ltd. The increase in investment in associated companies of ~S$0.9 mil was due to share of profits contributed by the associates in OZ S.p.A and Yokohoma Tire (Shanghai) Sales Co Ltd.

The increase in current liabilities of ~S$8.5 million was primarily due to increase in trade payables of ~S$2.6 million from higher trading activities and an increase of ~S$5.0 million in current bank borrowings. Our cash flow for the period showed a net decrease in cash of about S$4.2 million in Q1'07 as compared to a net decrease of ~S$8.0 mil in the same period last year primarily due to lower capital expenditure spendings.

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